Over the past year, global currency markets have been quite volatile. Aggressive rate cut actions undertaken by many central banks to spur weakening economic growth are largely to blame for this. In some countries in Europe, interest rates are now negative.
In India too, the RBI resorted to a series of rate cuts to aid economic growth. This, among other factors, contributed to a weakening of the rupee (INR) vis-à-vis the dollar (USD). Over the past year, the INR has weakened about 1.8 per cent against the USD and now trades at about 70.9 to the dollar. The 52-week USD-INR exchange rate range is 68.29–74.14.
Since currencies are relatively valued against one another, and the bulk of global trade happens in USD, some fundamental factors could influence how the rupee fares against the dollar.
Interest rate and inflation
In general, a higher interest rate in a country attracts capital inflows from abroad. This helps strengthen the country’s currency. By extension, the interest rate differential (difference in interest rates between the two countries) plays a part in currency movement. An increase in the differential aids the currency of the country with the higher interest rate, while a decrease in the differential weakens the currency.
The policy rates of the RBI and the US Fed are now 5.15 per cent and 2 per cent respectively. That is, the interest rate differential is 3.15 percentage points. This is down from 4 per cent in the beginning of 2019. In the coming months, the RBI is expected to lower rates further while the Fed seems to be in no hurry to cut more. So, the differential could drop, putting greater pressure on the rupee.
Like interest rate differential, a difference in inflation between countries also impacts the exchange rate. In general, higher the inflation, weaker the currency. That’s because, among other factors, higher inflation makes manufactured goods in a country more expensive and reduces export competitiveness, thus curbing the demand for the currency. By extension, an increase in the inflation differential weakens the currency of the country with the higher inflation.
Headline inflation in India and the US, as per the latest data, is 3.99 per cent and 1.7 per cent respectively — a differential of 2.3 percentage points, but up from just 0.35 percentage points earlier this year. The wider inflation differential would also have weighed down on the rupee.
Looking ahead, the RBI has retained its inflation expectation for H2 FY20 and Q1 FY21. This means that, if inflation in the US stays around current levels, a higher inflation differential seems unlikely – this should give the rupee a breather.
Current Account Deficit
Among the major factors that influence currency movement is a country’s current account deficit (CAD) — in simple terms, the excess of its imports over exports. The higher a country’s CAD, the weaker its currency. That’s because the country will demand more foreign currency to import, while the demand for its own currency will be lower.
According to the latest RBI data, India’s CAD saw an improvement in the first quarter of FY20 — narrowing to $14.3 billion (2 per cent of GDP) from $15.8 billion (2.3 per cent of GDP) in the first quarter of the previous year. India’s exports have been slowing, but imports have been shrinking faster, resulting in a lower CAD.
Trade deficit, the largest component of India’s CAD, has marginally increased to $46.2 billion in the first quarter of FY20 from $45.8 billion in the same quarter last year. Deficit in primary income went up to $6.1 billion from $5.8 billion. But this was mitigated by a rise in surplus in the service component (to $20 billion from $18.7 billion) and secondary income components (to $18 billion from $17.1 billion).
The major component of India’s import bill is crude oil and it is expected to stay subdued through Q2CY20, according to latest outlook by the US Energy Information Administration. This should help the rupee.
Forex reserves
The higher a country’s forex reserves, the better it is for a country’s currency, as it gives the country more fire-power to deal with unexpected wild swings in the exchange rate or factors such as the balance of payment.
As per the RBI’s weekly statistical supplement released on October 18, India’s foreign exchange reserves have hit an all-time high of $439.7 billion, up 10 per cent since January this year. This is positive for the rupee.
Of the four components of forex reserves, the largest is foreign currency assets at $407.9 billion, higher by nearly 11 per cent from $367.9 billion early this year. Noticeably, gold holdings too have increased 21 per cent to $26.8 billion, from $21.2 billion. The reserve position in the IMF also increased $3.6 billion from $2.6 billion. The special drawing rights are at about $1.43 billion, a tad less than they were at the beginning of the year.
Foreign investments
A higher flow of foreign investments into a country bodes well for its currency, while outflows can be a drag.
The financial markets seem to be gaining foreign investor confidence and seeing considerable inflow. During the April-September period of the current fiscal year, foreign portfolio investors (FPIs) have made net investments of ₹38,917 crore in equity and debt combined whereas they net sold ₹74,757 crore in the same period the previous year.
Foreign direct investments (FDI), which are more durable than FPI investments, saw an increase as well. In the current fiscal, until August, FDI investments made were ₹20,207 crore according to RBI data. This is 50 per cent up from ₹13,401 crore in the same period of 2018.
These foreign fund inflows helped the rupee stabilise this year and, if they sustain, could help buoy the currency.
Market sentiment
Apart from fundamentals, market sentiment often influences the currency market. For instance, India’s GDP growth declining to a multi-quarter low of 5 per cent in Q1FY20 had a negative impact on the rupee. To mitigate the woes, the government announced a slew of measures, including the landmark corporate tax cut, which boosted investor sentiment and helped the currency stage a recovery. How the economic situation and market sentiment evolve in the country over the coming quarters will have a bearing on the rupee.
One needs to be watchful of geopolitical developments as they often lead to currency volatility. Events including the US-China trade talks, Brexit, unrest in West Asia and protests in Hong Kong could hit the currency market. Negative news could make investors shift to safety, pushing up demand for the dollar (considered a safe haven in volatile times) and further impacting the rupee.
Looking ahead
Steeper than expected rate cuts by the RBI and geopolitical uncertainties could weigh on the rupee in the coming quarters. However, this could be mitigated by foreign capital inflows, improving CAD, subdued crude oil prices and the government’s measures to revive economic growth. The rupee can be expected to stabilise between 70 and 72.5 over the medium term.
Measured moves, rather than abrupt changes in the foreign exchange rate, could help the economy manage inflation better.